Synthetic Bonds Are the Answer to Euro-Area Crisis: Harald Uhlig

Oct. 21 (Bloomberg) -- The euro area is burning and policy
makers seem increasingly powerless to douse the flames.
Meanwhile, we can only stand by and watch this nerve-wracking
spectacle.

Yet the situation may not be utterly hopeless. In the last
month or so, researchers have floated proposals for the creation
of synthetic euro bonds that may offer a way out. The idea rests
on three principles: No cross-subsidization between countries;
safety; and the replacement of risky sovereign debt by synthetic
bonds in European Central Bank repurchases.

I know what you are thinking: Are these people out of their
minds? Collateralized debt obligations? Synthetic securities?
That is what got us into this mess in the first place.

Let’s take a closer look. The proposals all start with some
version of an open-ended mutual fund that would hold euro-area
bonds. Ideally, the fund would hold these assets in proportion
to the gross domestic product of each member country. It would
then issue certificates that would be fully backed by these
bonds. If there is a partial or full default on one of the
securities (Greek 10-year bonds, say), then the mutual-fund
certificates would lose some value.

In the case of a small country or a partial default, the
losses would be small. So, the certificates would be reasonably
safe.

The most important aspect, however, is that there would no
mutual bailout guarantees, no cross-subsidization between
countries and no need for high-level political brinkmanship.
This is the core of the proposal I put forth with my colleagues
Thorsten Beck and Wolf Wagner, of Tilburg University in the
Netherlands.

Safer Securities

We recognize that many people will say that reasonably safe
isn’t safe enough when it comes to synthetic securities. We
believe they could be made safer. Markus Brunnermeier and his
fellow members of the Euro-nomics group propose to divide the
mutual-fund certificates into tranches. The junior tranche would
be hit first in case of a default. The senior tranche would be
most protected and could be called “European safe bonds” or
“ESBies.” Both tranches would be traded on markets.

This would slice a slightly risky investment into several
parts, one of which is safe. It would be an important feature if
the ECB can’t be persuaded to use the raw mutual-fund
certificates directly for repurchasing transactions, or if the
original certificates are still considered too risky on bank
balance sheets.

The biggest disadvantage of this idea is that it is too
reminiscent of the infamous alchemy of 2008. I think it can work
if properly implemented.

Another proposal by two Italian economists, Angelo Baglioni
and Umberto Cherubini would create the original mutual fund, but
it would only buy senior debt from governments, which would be
required to post cash collateral. That is less appealing because
it would require too much political maneuvering, would too
easily allow cross-subsidization, and would entail restructuring
of current government debt to create securities of appropriate
seniority.

But the main point is this: It would be feasible to fine-tune any proposal to ease particular concerns of participants
regarding seniority and safety, as long as the three principles
I outlined above are obeyed.

The last of the three principles may be the most critical:
These certificates must replace risky sovereign debt in ECB
repurchasing transactions. One objection to this is that there
is no particular reason now, for, say, a Greek bank to hold
Greek debt or for a Spanish bank to hold Spanish debt, when they
could all hold much safer German bonds.

‘Hold to Maturity’

The banks that can still afford to mark their sovereign
debt to market, rather than “hold to maturity” and pretend all
is well, can do this now. They can ensure their safety by
selling the debt of Portugal, Ireland, Italy, Greece and Spain,
and buying German bonds.

The trouble with that scenario is that if all banks were to
act this way, the prices of those bonds might plummet. That
would mean far deeper trouble for Portugal, Ireland, Italy,
Greece and Spain the next time they try to issue new debt. It
would cause problems for the banks, too, as they would get even
less than what they currently think the bonds are worth.

The ECB has danced around this issue by repurchasing risky
sovereign debt, buying it outright in the open market,
supporting these prices through intervention, and trying to
unwind again. The ECB is ultimately backed by the euro area’s
taxpayers, who either get more inflation or a depreciation of
their currency, if things turn south.

In addition, the central bank’s actions have had the
unintended effect of encouraging private banks to hold the risky
assets, rather than discouraging them from doing so. This makes
sense: These bonds get higher returns, are still usable as
collateral with the ECB, and are implicitly guaranteed by
government bailouts if things go wrong. The real loser is the
taxpayer.

The mutual-fund construction removes much of this moral
hazard. It can buy a sizeable fraction of the risky debt, taking
it off the books of the ECB and the commercial banks. Yes, it
may still need to buy German, Dutch and Finnish bonds on the
market, but the banks, in turn, would buy these certificates.
And, importantly, the ECB uses the mutual-fund certificates or
their ESB-safe versions for its repo- and open-market
transactions, while gradually phasing out its support of
individual risky sovereign debt.

Who can create these certificates? A savvy market
participant could probably pull this off in a few days. But it
would be better to have a public institution do it instead.
Competition among several such funds may even be better, with
the ECB deciding which ones to accept and which ones to phase
out. In any case, this can be done quickly, if decision makers
in government and the financial-market institutions can be
persuaded to act.

This isn’t a glamorous, magic solution. Nor is it a sexy
proposal for politicians to sell in speeches. This is a simple
step forward that wouldn’t cost much, but is easy and effective.
Most of all, it is what the euro area needs right now.

(Harald Uhlig is chairman of the economics department at
the University of Chicago and a contributor to Business Class.
The opinions expressed are his own.)